Testing Real Interest Parity in the European Monetary System

Abstract

Current discussions on Economic and Monetary Union (EMU) in Europe have stressed the need for enhanced integration of goods and factor markets as a pre-condition of moving as costlessly as possible to a single currency system. The real interest differential--and hence tests of real interest parity--provide a summary measure of the degree of residual integration necessary such that these conditions are met. Empirical tests suggest a rejection of real interest parity among European Monetary System (EMS) member countries, at least during recent years. Further, a decomposition of the differential suggests that imperfect integration of goods markets, as reflected in a failure of ex-ante PPP, is largely responsible for this finding.